One of the first pieces of advice I give to those just starting a business is to separate your personal and business finances. Set up a separate business bank account and obtain a separate business credit card. Keeping your finances separate helps you better track your business activities and will clarify income and deductions for tax purposes.

With that being said, some business owners still have their companies pay their bills. What are the tax ramifications to this you might ask? Here are some tax cases to illustrate:

S corporation paid owner’s taxes on his home. The taxpayer was the owner of a business that was set up as an S corporation. The corporation cut checks payable to the county where the owner’s home was located in the amount of the real estate taxes on the residence. The corporation did not take a deduction for the payment; he deducted them as an itemized deduction on his personal return.

Usually, when an S corporation pays a personal expense of an owner, the owner is treated as receiving a constructive dividend (a nondeductible payment by the corporation) but is also treated as having constructively paid the obligation that had actually been paid by the corporation. Fortunately, in this case the Tax Court was sympathetic to the owner. The payment of the owner’s personal real estate taxes by his corporation was viewed as a nontaxable distribution to him; he could treat it as having constructively paid the real estate taxes.

Corporation paid owner’s personal insurance and utilities. The taxpayer’s corporation paid his life, home, and auto insurance as well as the utility bills for his home. The corporation deducted the outlays, but the IRS claimed they were nondeductible dividends to him. The Tax Courts found the corporation’s payments to be additional compensation to the owner, which was deductible by the corporation (and taxable to the owner).

Note: The case preceded the favorable tax treatment that now applies to qualified dividends received by shareholders. While the dividends are not deductible by the corporation, they are also not subject to employment taxes. It’s not clear whether the results would be viewed as favorable or unfavorable today.

Corporation’s services for shareholder. A shareholder of a construction company had his business pay for materials and labor to build his vacation home. He reimbursed the corporation for the cost of these items. The IRS said he had a constructive dividend equal to the foregone profit that the corporation would have earned if the items were provided to a third party, but the Tax Court said no.

Bottom line

While taxpayers may prevail against IRS charges arising from corporate payments of personal expenses, there’s a better way. Avoid the charges entirely by paying your own expenses. Where needed, increase compensation so that you won’t have to litigate the issue of additional compensation or constructive dividends.

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